In their quest to gather assets, some smaller funds of hedge fund firms are offering deals on performance fees to plan sponsors.
Alan Dorsey, managing director and director of hedge fund investment and research at CRA Rogers
Casey, Darien, Conn., said he has seen examples of fund of funds with less than $500 million under management that are willing to deal on fees. The goal, he said, is to gather enough assets to attract the attention of consultants conducting hedge fund searches on behalf of institutional investors.
"The more assets under management they can get, the higher brand-name awareness they can achieve," Mr. Dorsey said. "Eventually they want to get big enough to enable them not to have to deal on fees."
But that raises other concerns, he added. As these funds of funds grow, future clients will be paying the full fees, effectively subsidizing the earlier investors.
"I have a real problem with that," Mr. Dorsey said.
The fee dealing takes various forms. A fund of funds will typically charge a management fee of between 1% and 1.5% and a performance fee of around 10% of positive returns above some hurdle rate. But smaller firms have offered combinations of discounts on management fees and performance fees or equity stakes in the company, Mr. Dorsey said.
Christopher J. Acito, a principal at Casey, Quirk & Acito LLC, Darien, Conn., said getting institutional business can be a chicken-and-egg problem for some funds of funds.
"How do you get the first couple of mandates, so you can then get more?" Mr. Acito said. "For some of these funds, it's important to land a couple of big clients. People are dealing on fees, and they're doing it for no mysterious reasons. If you own a restaurant, you give your best customers a seat at the table and buy them the dessert for free."
Mr. Acito said he doesn't see anything wrong with cutting performance fees to attract business. The more important question to ask, he said, is whether a plan sponsor that recently hired a fund of funds manager did so based on price.
Jane Buchan, managing director at fund of funds Pacific Alternative Asset Management Co., Irvine, Calif., said she doesn't think many plan sponsors are swayed by fee discounts. Moreover, she said, she doesn't necessarily believe the standard fees for funds of hedge funds are the often-quoted 1% to 1.5% and 10%. PAAMCO, she said, charges a 1% fixed management fee and no performance fee. She said she thinks her firm is "right on the mark" when it comes to what other funds of funds charge.
Which suggests that some funds of funds might charge a performance fee and hope plan sponsors won't question them on it. If the sponsor does object to the performance fee, it's easy to cut or eliminate because it isn't part of the cost structure of the firm, she said.
"The fund-of-funds space has just exploded," Ms. Buchan said. "There are a lot of new entrants there. So how do you attract attention? Saying you're willing to lower fees is one way to do it."
Ms. Buchan said PAAMCO has won mandates from institutional investors, despite charging higher fees than any other finalists, because most institutional investors want performance and diversification and are willing to pay for it.
Not a major factor
That's the case at International Paper Co., Stamford, Conn. Carol Tusch, director of trust investments for the $8.6 billion pension fund, said when officials there recently hired two funds of funds, fees were not one of the major factors in the decision.
Instead, International Paper officials looked to make sure the funds were either multistrategy or a fund of funds, had a "manageable amount of assets" under management - $4 billion or less - followed a multifactor and beta-neutral strategy, and had sufficient resources and a stable organization, Ms. Tusch said.
Mr. Acito said trying to win funds by being the low-priced alternative can be risky. In the end, the company has to make enough money to cover its costs. For that reason, it tends to be the smaller funds of funds, those with a couple of hundred million under management, that are dealing on fees, he said.